After years of food industry share outperformance relative to the broader stock market, the sector’s reversal in 2017 was extraordinarily severe, said Brett M. Hundley, Vertical Group, Richmond, Va.
As a result, Mr. Hundley said food sector shares are valued far differently at the start of 2018 than was the case a year ago or several years earlier. Mr. Hundley was one of several food sector analysts interviewed by Milling & Baking Newsabout the stock market outlook for the new year in the food sector generally and grain-based foods in particular.
“Since 2006, the packaged foods subindex has always traded at a premium to the market,” Mr. Hundley said. “Over the past two to three years the multiple has been 1.4 to 1.5 times. Now it is sub-1. I’d never seen that. It just shows the rotation toward industrials and tech and away from these staple names.”
Other analysts offering a market out-look were Farha Aslam, managing director, Stephens, Inc., New York; Kevin V. Dreyer, co-chief investment officer, value, Gabelli Funds, New York; and Nicholas Fereday, senior analyst, consumer foods, Rabobank, New York.
Each of the analysts cited changes in food retailing as a key market influence in 2017, notably the acquisition last year of Whole Foods Market, Austin, Texas, by Amazon.com, Inc., Seattle.
“A lot of (the food sector weakness) has to do with the upheaval in retail — Aldi /Lidl and Whole Foods/Amazon,” Mr. Hundley said.
Food companies and retailers will adjust to the changing circumstances, but it will take a while, he said.
He cited financial results announced recently by Kroger Co., Cincinnati, showing improved performance and steps the company is taking in response to changing consumer behavior.
“Sometimes consumers want to shop, and sometimes they want to pick up their groceries in a car,” Mr. Hundley said. “Sometimes they want to have it delivered. Those who sell food need to react, and there is a domino effect to packaged foods companies and their suppliers. Everyone is trying to find their way, and they will.”
Ms. Aslam characterized 2017 as a “challenging year” for the food sector overall but noted varied performance by sub-sector.
“There have been pockets of strengths, including the protein stocks,” she said.
Large cap packaged foods companies have had a more difficult time, she added.
“Volume growth in U.S. packaged foods has been challenged by changing consumer demographics with a growing interest in eating fresher, healthier foods,” she said. “The large-cap food companies have been facing pressure because of the retail market share wars. You’ve had the entry of Aldi and Lidl into the U.S. marketplace. You’ve had Amazon buy Whole Foods and the growth of e-commerce.”
That the acquisition of Whole Foods by Amazon sent shock waves through the food and beverage industry was strongly echoed by Mr. Dreyer. Whole Foods shares were in the Gabelli fund portfolio ahead of the Amazon move, yielding gains for fund investors. Still, he said the transaction was hardly all good news.
“We obviously benefited from the takeover of Whole Foods by Amazon, but the ramifications of that deal and negative sentiment toward food and beverage have really weighed on the stocks,” he said. “The notion is that Amazon is getting much bigger in food and will put pressure on manufacturers.”
For Gabelli, health and wellness has been an investment theme the company has pursued with success for some time. A theme that has not panned out as well has been consolidation.
“There have not been a lot of major deals,” he said.
While The Kraft Heinz Co. (3G Capital), Pittsburgh, made an unsuccessful bid to acquire Unilever P.L.C., London, the deals that were successfully completed through much of 2017 were smaller, such as the Danone S.A., Paris, acquisition of The WhiteWave Foods Co., Denver, or the McCormick & Co., Hunt Valley, Md., acquisition of the food business of Reckitt Benckiser L.L.C., Slough, U.K.
“There are a few reasons consolidation hasn’t happened,” Mr. Dreyer said. “There has been uncertainty over taxes. The market has been waiting all year for a tax deal. Whether you get a deal or not, uncertainly has caused a certain amount of reticence among c.e.o.s and boards to do transformational transactions.”
His thesis, shared in an early December interview, appeared to be borne out by the sudden wave of transactions announced in the final weeks of the year, coinciding nearly perfectly with congressional passage of tax reform legislation.
In any event, Mr. Dreyer said the market reaction to the Amazon/Whole Foods transaction appears to have been excessive.
“After the deal, you’d see headlines about how large Amazon is getting,” he said. “That hasn’t been borne out. Mondelez has posted strong results. Conagra has as well. Campbell and General Mills have had choppier results. This notion that it is Amazon exerting pressure on industry, it’s not in the numbers yet. Whole Foods had 450 stores. That’s less than 1.5% of the food market.”
Meanwhile, Amazon has retrenched in other parts of its food retail initiatives, exiting Amazon Fresh in several states.
“They’re still trying to figure out the right formula,” Mr. Dreyer said.
Mr. Dreyer noted sales of large brands over-index in e-commerce versus performance in traditional brick-and-mortar stores. Still, the shift in focus toward e-commerce represents a cost for large food companies presently.
“Companies are investing in online promotion and display,” he said. “They’re trying to figure out how they are going to compete in e-commerce, but they are going to do it.”
Looking forward to trends expected to emerge in 2018, Mr. Hundley said efficiency will be a major theme for food and beverage companies in 2018.
“Broadly, I think it’s going to be another year of s.k.u. (stock-keeping unit) rationalization,” he said. “That has been a major storyline between 2017 and 2018. All major companies have talked about becoming more efficient. That is playing out against a situation among retailers in which grocers are starting to alter their assortment in stores. Target and Kroger are starting to minimize linear square footage for soup and increase linear square footage for product categories like beverages.”
More generally, supermarkets may downsize in the years ahead, Mr. Hundley said.
“I think grocery stores are way too big,” he said. “I foresee in coming years that U.S. grocers are going to trim the amount of in-store space devoted to food and beverage. That will have consequences for food and beverage producers. As retailers shrink space and potentially devote space for fulfillment centers for pickup delivery or potentially introduce clothing lines like Kroger is set to do or team up with electronic retailers. Or share space with a gym. I think you’ll see grocers get creative with how they utilize space. I see that with potential to pressure distribution for some packaged food and beverage producers in the United States.”
The rate of change in the food sector has accelerated to an extraordinary pace, said Mr. Fereday. Food companies are scrambling to make acquisitions to realign product portfolios to meet the changing taste of consumers for products such as plant-based protein, he said.
“There are companies being bought today that didn’t exist three to four years ago,” he said .
Emblematic of the pace of industry change is the fact that the banner event of the year — the Amazon acquisition of Whole Foods — was unexpected in the industry.
“How is it possible no one in the food industry saw that coming?” Mr. Fereday said. “It creates a series of ‘what’s next?’ scenarios.”
Many key forces at play going into 2018 were prominent features a year ago, Mr. Fereday said.
“Top-line growth is still a struggle,” he said. “Food companies are still trying to renovate. Cost cutting is a factor with 3G pressure hanging over them. There is interest in small companies to shift the gravity in line with consumer trends, and valuations are rising. In the past, companies talked about how they like to get to know a company before considering an acquisition.”
Meanwhile, innovation coming from within large packaged foods companies has been scant, Mr. Fereday said.
“We are waiting for some brilliant ideas from large companies, wondering whether companies will surprise us,” he said. “Have they given up on internal ideas? Is it a cost consideration?”
He said the days of an army of research and development staff appear over in the world of 3G Capital, New York. He described a struggle between meeting near-term (shareholder) goals and long-term objectives.
“This represents an existential threat to large food companies,” he said. “A clock is ticking. At what point do we ask, ‘Have these investments (in small companies) made any returns for us?’ At what point do you start giving them a scorecard? How much time do you give them?”
|||READ MORE: Mixed bag 'likely once again' in 2018|||
Mixed bag ‘likely once again’ in 2018
Going into 2018, Farha Aslam, managing director, Stephens, Inc., New York, said a mixed bag is likely once again with a mixture of winners and losers.
“Companies in the right categories will be well positioned,” she said. “Companies that focus on the periphery of the store, particularly on produce and protein and deli will do well. Companies with strong innovation such as Pinnacle and B&G Foods will benefit from the growing interest in frozen. Companies with successful M.&A. programs, for example, Hormel, will do well.”
High on Ms. Aslam’s list of promising companies is Calavo Growers, Inc., Santa Paula, Calif.
“Calavo is an avocado company with a strong presence in guacamole and a growing business in fresh cut fruits and vegetables as well as meal kits,” she said. “It has done well and is very well positioned with its supply chain and distribution capabilities to succeed. We believe it will continue to perform well.”
Protein companies also are likely to do well in 2018, she said.
In grain-based foods, Ms. Aslam has a neutral view toward Flowers Foods, Inc., Thomasville, Ga., but is upbeat about Hostess Brands, Inc., Kansas City.
Flowers Foods has eyed and struggled with the periphery of the supermarket with its acquisition of Alpine Valley Bread Co., one of two organic bread baking businesses Flowers acquired in 2015. That the second and larger acquisition, Dave’s Killer Bread, has done well and Alpine has struggled does not surprise Ms. Aslam.
“The periphery of the store has its own supply chain, its own buyers,” she said. “It is a different skill set. As they move in, there is a lot of learning to be done.
“Flowers acquired two organic brands — D.K.B. and Alpine. Alpine was purchased partially because they had capacity to produce D.K.B. In that sense, the acquisition has been a success because they got the capacity. Alpine as a brand has struggled because there has been so much growth and focus on D.K.B.
“They want Alpine in their portfolio. They’ve recently hired a new chief marketing officer, and that c.m.o. will look at their whole brand portfolio and really segment where each brand should play. I think that will help Alpine going forward.”
Tempering Ms. Aslam’s view of Flowers has been the “lackluster” performance of the company’s core portfolio. She emphasized efforts by Flowers to invigorate the business through the hiring of Debo Mukherjee as c.m.o. and cost reductions necessary to fund increased marketing and innovation.
“Our neutral view reflects our concerns that there may be need to invest in marketing and innovation ahead of the cost savings, which will dampen earnings for fiscal 2018,” she said. “The cost inflation they will face along with the marketing investments we believe are going to be quite significant in the near term. We think Project Centennial is the right long-term direction for the company. Near term, we think earnings are going to be subdued because of the investment.”
Notwithstanding doubts that have been expressed about whether Hostess Brands will sustain its momentum, Ms. Aslam remains upbeat about the company’s prospects.
“They articulated a target for this year and are well positioned to hit the target,” she said. “The growth was very first-quarter and fourth-quarter weighted. Mid-year doubts emerged as to whether they could hit their full-year numbers. There is no history of this company in the public markets and the management team. We are very positive on Hostess. They have done a terrific job of growing shelf space with innovation.”
For example, Ms. Aslam described the company’s recently introduced Bakery Petites as “on trend.” She noted that the product made its debut at Walmart and is being rolled out more broadly.
“Hostess innovations have a lot of legs,” she said. “Chocolate Twinkies, peanut butter Ho Hos, an expanded breakfast line. They are introducing very high quality innovation.”
Brett M. Hundley, Vertical Group, Richmond, Va., is more upbeat on Flowers’ prospects, despite the company’s challenges. Vertical Group has rated Flowers a buy since initiating coverage in December 2016 (at $15.48 per share).
“We’re very positive on Flowers,” Mr. Hundley said. “They are clearly facing ongoing headwinds in the fresh bread category. We also think they’ve been somewhat outmaneuvered on the cake side by Hostess, but we are very encouraged to see them executing on Project Centennial cost savings plan. I think it will put them in a much better competitive position to be able to spend brand support dollars against product innovation and distribution.”
Also a positive at Flowers is the company’s position in the organic marketplace with Dave’s Killer Bread, a brand with further growth potential, Mr. Hundley said.
“The last few years have been difficult for Flowers, but we do see a viable pathway toward sales growth generation and improving margins ahead,” he said.
Other grain-based companies viewed favorably by Vertical Group include TreeHouse Foods, Inc., Oak Brook, Ill., and Lancaster Colony Corp., Westerville, Ohio.
TreeHouse was upgraded to a buy rating in November from a hold.
“TreeHouse has quickly become one of our favorite names,” he said. “We acknowledge the high leverage profile in place. We acknowledge the many missteps by management as it has integrated the Ralcorp asset from Conagra. We think this is a true case of growing pains. This company got too large too quickly. And while it’s found itself in a tough spot as a result, we do think this is a bottom, and we are encouraged by technology that has been put in place recently across the company that will now allow it to analyze profitability by plant, s.k.u., customer, etc. We do see a pathway out as the company reduces a far-too-complex s.k.u. count while also streamlining operations. With the valuation where it is today relative to the peer set, if they can execute their way out, we see a lot of upside for the shares from current levels.”
The appeal of Lancaster Colony is not its valuation, Mr. Hundley said. Instead, Vertical is attracted to its strong positioning in traditional food retail as well as food service. Lancaster manufactures a range of dressings and dips as well as various baked foods and noodles. Mr. Hundley described the company as “high quality” and “robustly” valued with a clean balance sheet.
“It’s not sexy,” he said. “They’re not involved in snacking per se. They’re not overly weighted toward organic or natural. But they’re positioned well in growth areas of grocery, along the perimeter in fresh or frozen. Their Flatout flat bread is sold along the perimeter. They sell frozen bread. Outside the grocery store, they’ve enjoyed good growth in food service.”
In the ready-to-eat cereal sector Kevin V. Dreyer, co-chief investment officer, value, Gabelli Funds, New York, favors Post Holdings, Inc., St. Louis. The largest players in the space — Kellogg Co., Battle Creek, Mich., and General Mills, Inc., Minneapolis — “have had their issues,” he said.
“At General Mills, certainly the yogurt business has been a disappointment for many years,” he said. “The company’s new Oui line by Yoplait seems like a good play, but we will see about execution.
“Kellogg is doing an okay job as they morph toward snacks.
“At Post, they are performing well in cereal. Post has very capable management. I expect them to continue to integrate acquisitions.”
A bit more cautious toward Post is Mr. Hundley, rating the company a hold.
While Vertical’s view of Post has been improving, he said caution is justified because of the company’s high level of debt.
“They do run this enterprise like private equity,” he said. “So, the argument can be made they can maintain a higher debt profile relative to peers. It’s something to be wary of in our opinion. We have a high degree of respect for this management team. Because they manage like private, they can engineer value more quickly for shareholders.
“Some of their business areas are of some concern for us. They’ve been able to realize a lot of value in their cereal business from combining Malt-O-Meal with Post, but we’re somewhat wary of the category in general and commentary from Kellogg and General Mills that suggests they will become more engaged with their own businesses.”
Still, he noted that the Post Michael Foods business is rebounding with the potential to drive earnings growth. He said cost synergy savings from more recently acquired businesses/brands (Weetabix and Bob Evans) represents an opportunity.
“There is a fair amount of center-of-store exposure in Post,” Mr. Hundley said. “That keeps us somewhat grounded with our forward expectations.”
While recommending a handful of companies, Mr. Hundley maintains a fairly sober view of prospects for the packaged foods sector overall and instead sees promise in companies focused on value-added ingredients.
He said, “For food companies to regain revenue growth profiles they want either 1) they will need to become more amenable to a lower margin profile, or 2) they will become even more leaner and take out incrementally more in the way of cost in order to try to maintain margin structure while still generating revenue growth. It’s really a tale of two stories between packaged foods and ingredients. Packaged foods revenues are under pressure. They are fighting like crazy to maintain margins, and their leverage profiles have worsened. A large part of that is expensive deal-making. They’re trying to gain greater scale through M.&A., and that M.&A. is proving expensive.
“Ingredient companies are still seeing very good revenue growth. Balance sheets are in great shape. They have to work to maintain the margin structures, but thus far they are in much better shape than their packaged foods customers further downstream. The ingredient space is vast, depending how you define it. We typically look at the specialty ingredients market, which would be ingredients that aren’t as commoditized.”
Mr. Hundley said Vertical estimates annual global sales of specialty ingredient total about $75 billion annually.
He noted that companies such as Ingredion Inc., Westchester, Ill., and Tate & Lyle P.L.C., London, have taken steps in recent years to tilt their ingredient portfolios more heavily toward specialty ingredients. A major step in that direction for Ingredion was the company’s (formerly known as Corn Products International) $1.3 billion acquisition of National Starch in 2010.
“They have continued to pursue that specialty mix, with the acquisitions of Penford Corp. (in 2014) and Kerr Concentrates (in 2015),” Mr. Hundley said. “I think the pursuit has helped their valuation to a degree, but it still lags the peers. We see a group today that trades at almost 25 times forward e.p.s. and almost 16 times forward EBITDA. A really expensive group but warranted in our view because revenues are growing, margins are relatively stable and balance sheets are strong. Plus there is a lot of consolidation potential ahead. It is a fragmented group.”
Ingredion and Tate & Lyle also have benefited from improved market conditions in the companies’ more commoditized ingredient businesses.
“When Cargill closed its Memphis plant, that greatly reduced supply of commoditized sweeteners and starches and swung the pendulum in favor of the U.S. corn wet milling industry,” he said. “It has seen robust margins on more commoditized ingredients in sweeteners and starches.”
At the same time, Mr. Hundley expressed concern over the highly fragile state of negotiations over NAFTA. Noting the significant level of U.S. high-fructose corn syrup (HFCS) shipments to Mexico, he warned that an interruption of that trade could have significant effects on the U.S. sweetener supply/demand situation.
He said his concerns were mollified by November presentations by Ingredion executives during an investor day presentation.
“First of all, Ingredion is not as commoditized as we originally thought in the United States,” he said. “Second, there has been talk out of Mexico that if NAFTA does dissolve, that Mexico may not react as strongly on U.S. HFCS as had once been thought. Mexico not only needs U.S. corn, but also needs U.S. corn sweetener. It also relies heavily on the U.S. for own sugar exports. So, the end result is it doesn’t want to get into a trade spat on cross-border trade related to sweeteners.
“We see very supportive fundamentals for specialty sweeteners and starches going forward. We expect growth at mid-single digit rate or higher going forward. The main support for that is changing formulations with packaged foods and beverages industries. As the companies change formulations away from synthetic ingredients toward natural ingredients, formulations become upended, and stabilizing ingredients are required in order to bring flavor and texture profiles back to the original product state. Specialty sweeteners and starches are prime remedy for the challenges, important for the move toward natural.”
Other companies Vertical rates favorably are Sensient Technology Corp., Milwaukee, and Innophos Holdings, Inc., Cranbury, N.J. The attraction of Sensient is the combination of both colors and flavors in its product portfolio, Mr. Hundley said. He said valuation make Innophos attractive.
